The market rarely provides buying opportunities where the risk to value proposition is extremely disconnected, but the natural gas market is having one of those moments now.

The news could hardly be more bearish for prices.

The nation's limited gas storage capacity, estimated at roughly 4 trillion cubic feet, is approaching the full line. Consumption has crashed 36% from 2.7 trillion cubic feet in January, to 2.1 trillion in March, to 1.7 trillion cubic feet in April. Stockpiles remain 18% over the five-year average.

Summer temperatures have been remarkably moderate, making for a lower-than-usual demand on gas-fired power plants for air conditioning. Weather forecasts expect temperatures to remain below seasonal levels.

With little other news to drive the trade, everyone is focused on inventories. The Energy Department's weekly inventory report showed that stockpiles had grown by 66 billion cubic feet to 2.95 trillion cubic feet, and that was enough to drive natural gas prices down 6.4% to $3.55 per million Btu on Thursday, giving the popular United States Natural Gas Fund (NYSE: UNG) a 6.7% loss on the day.

Meanwhile, supply continues to grow. An exciting new field called the Granite Wash play in the Texas panhandle and western Oklahoma is showing prolific production rates. Newfield Exploration (NYSE: NFX) claimed average initial production rates of 22 million cubic feet per day from its seven horizontal wells this week, giving its stock a nice 11% bump on Thursday. Forest Oil Corporation (NYSE: FST), another driller in the Granite Wash and the Haynesville Shale, saw its stock rise 14% the same day.

Another growing horizontal shale play is the Eagle Ford field in south Texas, where St. Mary Land & Exploration Co. (NYSE: SM) has claimed a 5.6 million cubic feet per day flow rate of oil and gas equivalent from one of its wells.

Horizontal shale gas plays are nothing new to readers of this column, of course. Producers of the Marcellus Shale and Haynesville formations are still drilling profitably, even while producers of the Barnett and Fayetteville formations have been forced to scale back drilling due to their higher production costs. Barnett producers claim they need gas back in the $6-8 range before they'll resume drilling.

To the north, the latest and greatest gas shale story is the Horn River Basin, in northern British Columbia. Exxon Mobil (NYSE: XOM) believes its first four wells will produce between 16 to 18 million cubic feet of gas per day—about five times the flow rate of a typical Barnett shale well. The basin's potential is unknown, but some speculate that recoverable reserves in the basin may run from 10 to 60 trillion cubic feet.

Such a supply glut and anemic demand certainly seems to portend low gas prices for the foreseeable future. Bearish analysts eager to make the early call are even suggesting $2 gas by the end of the year.

I don't believe it for a minute.

Was the 2001 North American "Peak" Wrong?

The explosion of North American shale gas and tight sands gas plays has made a bit of a stir in peak oil circles. These unconventional gas sources pushed the continent's production in 2007 over the 2001 peak of 33.8 trillion cubic feet (EIA data), seemingly putting an end to the notion that North American gas had peaked and gone into terminal decline.

Complete official 2008 data is not yet available for all of North America, but I estimate that its gas production for the year came in at around 35.2 trillion cubic feet, roughly 4.3% gain over the previous 2001 peak. Graphically, it looks like this:

North American Natural Gas Production. Chart by Chris Nelder using EIA data for 1995-2007. 2008 data from EIA for the U.S., and estimated for Canada and Mexico.

Now, that may be a picture that gets some people excited, but not me. I know that unconventional shale gas wells deplete very rapidly, paying out 60 to 90% of their production in the first year. It takes a great deal of drilling to maintain overall production rates, and in a low-price environment like today's, the prospects for additional drilling are dubious.

For the straight dope on the North American peak question, I turned to David Hughes, the now-retired Canadian geologist who is a bona-fide expert on North American gas.

He pointed out that it has taken 33,000 successful gas wells per year to exceed the 2001 peak, and noted that rig counts are still well down from last year. (According to Baker Hughes, gas rigs operating in the U.S. are now down to 665, the lowest number since May 2002, and off 59% from September of last year.) It's hard to imagine how this will not result in diminishing supply, and Hughes expects we'll feel the effects some time in the next six to nine months.

Canadian gas production fell 11% year over year in April, he said, so these new unconventional plays will have to compensate for a rapid decline. He believes "the jury is still out" on the Haynesville Shale and other shale gas plays outside of the Barnett, as we still lack a detailed understanding of the formations, which ultimately determines the flow rates. The "core" Barnett is twice as productive or more than the non-core, so until we have more detailed information about the newer shale plays, we should take their cost and productivity projections with a large grain of salt.

When considering the North American gas peak, we must also bear in mind that over 50% of natural gas consumed in the U.S. today comes from wells drilled in the last three years, and 25-30% of the gas produced today comes from wells drilled last year, according to data from the IHS Energy Group

This is why Hughes has called unconventional gas a treadmill: because you have to keep drilling like crazy just to stay in one place.

So while we have indeed exceeded the 2001 North American peak, I think it's premature to expect production to keep rising from current levels when gas has spent most of this year at about half the price it needs to be for the lesser plays to be profitable.

There is no doubt that the domestic gas resource is large. According to a new study under the direction of the Colorado School of Mines, the U.S. has about 2,000 trillion cubic feet of natural gas reserves—enough supply to last for decades, even with increased demand.

But as my readers well know (all together now): It's not the size of the tank which matters, but the size of the tap.

Should drilling over the next three years fail to keep pace with the rapid underlying decline rates, that new 2008 peak will fade into just another bump on the long plateau of North American gas production. We should not be too quick to turn our backs on the supply issue.

Is Demand Really Dead?

Many investing analysts have focused on high inventory numbers and the mild weather as key forces pushing down gas prices. This has contributed to the gas market disconnect, since these are actually fairly marginal drivers.

The lack of demand is the most important factor weighing on prices, with U.S. demand for all uses down 36% from January to April this year.

However, most of the loss in gas demand owes to the industrial sector. As I explained in my April natural gas analysis ("Natural Gas Under $4 Is a Steal"), gas consumption in the US is split roughly in thirds between commercial and residential demand (which is fairly constant), electricity demand (which grows at about 5% each year) and industrial demand. Vehicular demand, while up 6.2% over last year, is still a miniscule component.

Natural Gas Consumption by End Use. Chart by Chris Nelder using EIA data.

Demand outside the industrial sector is actually quite resilient. Gas consumption is off only slightly year-over-year as of April, with residential demand gaining 0.7%, commercial losing 4.1%, and electric power losing 1.8%. (April is a good month to consider for our purposes here, because the mild weather of the equinox months make them the low points of the seasonal demand cycles.)

Industrial sector demand, by contrast, is down a whopping 11.5%. Cutbacks in the production of petrochemicals, plastics, wood products, metals, motor vehicles and fertilizers, as well as lower gas demand for industrial boilers, are primarily responsible for the decline.

In short, we may expect demand to creep up again in concert with an overall recovery in the economy, particularly the manufacturing sector. Depending on whose estimates you believe, that recovery may be less than a year off.

Gas prices could easily double from today's levels when that happens, whereas it's hard to imagine much more downside risk with an unrelentingly bullish overall market sentiment in place since March.

More Bullish Factors

Climate change concerns will lend further support to gas demand. As carbon emissions start coming with a price attached, cleaner-burning gas will be increasingly favored over coal for fueling power plants. Many newer plants use dual-fuel designs, enabling them to switch readily to whichever fuel is cheapest. As the hidden subsidy of externalized emissions costs is taken away from coal, gas will be cheaper, and it will stay cheaper.

The vehicle angle is another hugely bullish factor for gas, but so far the markets don't seem to have discounted it at all.

As I have often suggested, the combined virtues of lower emissions, an inexpensive and large domestic supply, and its suitability as a bridge fuel to wean us away from oil will prove irresistible to policymakers, particularly as we begin to feel the effects of peak oil. Accordingly, a raft of new gas legislation is now working its way through Congress.

A huge win for the Pickens Plan and other natural gas vehicle boosters came early this week when the House overwhelmingly approved H.R. 1835, its portion of the so-called NAT GAS Act. The bill would authorize $30 million a year for the next five years for research and development, increase and extend tax credits for buying natural gas vehicles, and offer a suite of tax credits and other incentives to expand natural gas refueling capacity and push government vehicle fleets toward alternatives.

Assuming the new incentives become law, which seems a safe assumption, a significant chunk of new gas demand for vehicles could materialize right around the same time as the economy begins to recover. It wouldn't take much increased demand to blow right through the perceived gas "glut" we have today, and cause prices to spike. But it will take many months for drillers to catch up with rising prices.

The longer prices remain too low to sustain increased drilling, the more tension there will be in the price slingshot.

A year from now, I think we'll be looking back on those analysts who predicted $2 natural gas by the end of this year with the same sad regard that we now have for the ones who saw oil trading in the $40s in December and thought it was going to $25.

You may recall that's when I got bullish—because I knew that the price of oil was wrong. I feel exactly the same way about gas now.

Another reason to start getting bullish is the extremely bearish gas sentiment itself. We haven't seen gas prices stay this low in years, and gas continues to trade at an historically low price relative to oil on an energy basis. As Warren Buffett likes to say, "Be fearful when others are greedy, and be greedy when others are fearful."

Natural gas under $4 was a steal in April, and it's even more of a steal now. Ignore the nattering nabobs of natty who worry on about inventory numbers; that's all noise. Lift your eyes from your shoes to the horizon, and you'll see that there's only one direction that gas prices can go over the coming year, and that's up.

Until next time,

Chris

Energy and Capital

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